The drop in natural gas and oil prices in 2008 will force many exploration and production (E&P) companies to write off a "huge" amount of reserves, Raymond James & Associates Inc. energy analysts said last week.
Producers with long-lived reserves, high operating costs and/or a lot of proved undeveloped (PUD) reserves run the greatest risk of writedowns, wrote Raymond James analysts John Freeman, Pavel Molchanov and Kevin Smith. Because oil prices late last year suffered steeper price declines than natural gas, oil-weighted producers generally are more at risk, they wrote.
E&Ps now are required by the Securities and Exchange Commission (SEC) to use the closing price for oil and natural gas on Dec. 31 to calculate proved reserves. After this year, SEC reserves rules have been updated to favor producers (see NGI, Jan. 5). However, producers have to live with the rules as they stand, and the existing rules could have a devastating impact on a lot of companies large and small. In an interim report last week, ConocoPhillips announced that it is taking a $34 billion charge against 4Q2008 earnings, blaming most of the write-downs on revisions to North American proved reserves (see related story).
"For most companies, reserves are only reported once a year," noted the Raymond James team. "This time there is going to be more noise than usual in the reserve numbers given the meltdown in oil (and to a lesser extent natural gas) prices toward the end of 2008. The main reason for this volatility is that the SEC requires companies to use year-end oil and gas prices when assessing the economic viability of reserves. While these rules are (thankfully!) changing for the next reporting season, that will not help now."
Since Dec. 31, 2007, year/year oil prices have plunged 54%; gas prices have fallen almost 25%.
"These price declines indicate that marginal reserves (especially oil-weighted ones) that were on the books in 2007 are at risk of being removed from the proved category," noted the analysts. "Logically, long-lived producers -- in other words, those with high R/P (reserve/production) ratios -- are, in general, the most at risk, as are the higher-cost producers."
Proved developed and producing (PDP) reserves will take a hit in year-end E&P reports, but reserves that require a lot of investment to be placed on production, which include proved developed but not producing and PUDs, "are at risk of being declared uneconomical," the analysts noted. Because the SEC does acknowledge hedges, "even companies that have hedged a large portion of their production will not be immune to reserve write-downs."
Raymond James anticipates more hurdles for E&Ps through 2009. Analysts referenced a recent Tristone bank survey, which found that on average "banks are currently lending based on $50/bbl oil and $5.70/Mcf gas. Our channel checks suggest that this could fall to roughly $40/bbl and $5/Mcf, resulting in what could be a 10% to 20% reduction in borrowing bases, as banks try to take a more conservative outlook on commodity prices." Raymond James is forecasting gas prices to decline sequentially in the first three quarters of 2009, bottoming out at $4.25/Mcf in 3Q2009.
"The dangerous combination of a decline in PDP reserves and a further reduction of the bank's price deck will be painful for companies that have minimal liquidity under their borrowing base and hence have limited financial flexibility," said the analysts.
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